Why Do We Call Financial Instruments "Exotic"?

Because some of them are from Japan.

Three Republican senators have agreed to support the financial regulatory reform bill, making passage extremely likely. The legislation will more tightly regulate so-called exotic financial instruments like credit default swaps. When did people start referring to certain investments as exotic?

They've been doing it here and there for decades, but the term didn't become really popular until 1990. Many financial types have used the word "exotic" to describe newfangled or risky investments. For example, in 1980, then-chairman of the Federal Reserve Paul Volcker, who worried that speculating with borrowed money might destroy the already fragile economy, issued the following warning to bankers: "This is hardly the time to search out for new exotic lending areas or to finance speculative or purely financial activities that have little to do with the performance of the American economy." (Volcker continues to make the same argument. In a December 2009 conference, he singled out ATMs as perhaps the only useful financial innovation in the last 25 years.) Despite Volcker's prominence, his phrasing didn't go viral. It was Berkeley professor Mark Rubinstein's 1990 working paper, Exotic Options, that made the word a term of art in high finance.

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Rubinstein told the Explainer that he doesn't recall exactly why he chose the word exotic and acknowledges several possible sources for the coinage. First, some categories of options are named for their geographic origins. An American option allows its holder to buy or sell something at a particular price, regardless of its market value, anytime before the option expires. The European option, in contrast, can only be exercised on the expiration date itself. In both styles, which have been around for centuries, the value of the option is based on the difference between the fixed option price and the market price of the underlying asset at the time you exercise the option. (For example, if the option lets you buy a stock for $10, and you exercise it on a day the stock is selling for $100 on the market, the option is worth $90.) In 1987, executives at the Tokyo office of an American bank sold the first Asian option. Unlike the American and European versions, the value of the Asian option depends on the average price of the underlying asset over the period the option was held, not just the price at the moment the option is exercised. The allure of the hot new option from the Far East may have struck Rubinstein as exotic.

On the other hand, Rubinstein might have picked the term up at the track. Novice gamblers usually make straight bets, predicting which horse will win, place, or show. But there are other possibilities, known as exotic wagers. You can win the trifecta by picking the first-, second-, and third-place horses in order. Predict the fourth-placed pony as well, and it's a superfecta. In the 1970s and early 1980s, Rubinstein was researching a racetrack-betting tactic that guaranteed profits. (He published his system in the journal Management Science in 1981.) It's possible, he says, that the word exotic was in his mind from that earlier work.

Journalists were also familiar with exotic wagers, which underwent public scrutiny long before exotic financial instruments. Many track-watchers blamed a series of race-fixing scandals in the 1970s and 1980s on high-payout exotic bets, which made cheating worthwhile. (To put it in perspective, a successful $1 bet on the superfecta in the 2010 Kentucky Derby paid a whopping $101,284.60.) For years, newspapers published calls for an end to the exotic wagers, but the system survived the controversy.